Bond Report

Will Trump Oversee the Financial Apocalypse?

The president has indefatigably used the soaring stock market as the leading indicator of his success in the White House. But what if the stock market’s spike is less a vote of confidence than a harbinger of the radioactive bond market? And what happens when they both go belly-up?

Traders on the floor of the New York Stock Exchange on Black Monday, October 19, 1987.

By Peter Morgan/AP Images.

Jeffrey Gundlach is known around Wall Street as the Bond King. His Los Angeles-based firm, DoubleLine Capital, manages $116 billion, most of which is invested in bonds. He is also a bit of a Renaissance man, peppering his insights about the credit markets with astute references to Nietzsche, Mondrian, Escher, and Mad magazine covers. That’s why his answer to a simple question—“Why would anyone invest in bonds?”—from someone in the audience at Vanity Fair’s New Establishment Summit, held earlier this month in Los Angeles, was at once both startling and perceptive.

You would think that Gundlach would be a big fan of bonds, given that he’s the Bond King and all. But he isn’t, for reasons that go to the heart of why the financial markets are far more dangerous than the daily highs in the stock market and record-low interest rates would suggest. “I’m not a big fan of bonds right now,” he told my V.F. colleague Bethany McLean at the summit, “and I haven’t been really for the past four years, even though I manage them, and institutions have to own them for various reasons.”

Video: Jeffrey Gundlach and the Weight of a Global U.S. Market

Let’s face it: people’s eyes tend to glaze over when someone starts talking about bonds and interest rates. Which is why much of the audience inside the Wallis Annenberg Center for the Performing Arts, and those watching the livestream, probably missed the import of Gundlach’s answer. But the bond market is hugely important. The stock markets get most of the attention from the media, but the bond market, four times the size of the stock market, helps set the price of money. The bond market determines how much you pay to borrow money to buy a home, a car, or when you use your credit cards.

The Bond King said the returns on bonds have been anemic at best for the past seven years or so. While the Dow Jones Industrial Average has nearly quadrupled since March 2009, returns on bonds have averaged something like 2.5 percent for treasuries and something like 8.5 percent for riskier “junk” bonds. Gundlach urged investors to be “light” on bonds. Of course, that makes the irony especially rich for the Bond King. “I’m stuck in it,” he said of his massive bond portfolio. He said interest rates have bottomed out and been rising gradually for the past six years. (Rising interest rates hurt the value of the bonds you own, as bonds trade in inverse proportion to their yield. Snore . . .) Gundlach said his job now, on behalf of his clients, “is to get them to the other side of the valley.” When the bigger, seemingly inevitable hikes in interest rates come, “I’ll feel like I’ve done a service by getting people through,” he said. “That’s why I’m still at the game. I want to see how the movie ends.”

But it can’t end well. To illustrate his point about the risk in owning bonds these days, Gundlach shared a chart that showed how investors in European “junk” bonds are willing to accept the same no-default return as they are for U.S. Treasury bonds. In other words, the yield on European “junk” bonds is about the same—between 2 percent and 3 percent—as the yield on U.S. Treasuries, even though the risk profile of the two could not be more different. He correctly pointed out that this phenomenon has been caused by “manipulated behavior”—his code for the European Central Bank’s version of the so-called “quantitative easing” program that Ben Bernanke, the former chairman of the Federal Reserve, initiated in 2008 and that Mario Draghi, the head of the E.C.B., has taken to heart.

Bernanke’s idea was to have the Federal Reserve buy up trillions of dollars of bonds, increasing their price and lowering their yields. He figured lower interest rates would help jump-start an economy in recession. Whereas Janet Yellen, Bernanke’s successor, ended the Fed’s Q.E. program in 2014, Draghi’s version of it is still going, which has led to the “manipulation” that so concerns Gundlach. European interest rates “should be much higher than they are today,” he said, “. . . [and] once Draghi realizes this, the order of the financial system will be turned upside down and it won’t be a good thing. It will mean the liquidity that has been pumping up the markets will be drying up in 2018 . . . Things go down. We’ve been in an artificially inflated market for stocks and bonds largely around the world.”

Other credit experts have noticed, too. One of them, James Grant, is the editor of the widely respected Grant’s Interest Rate Observer, a bible of sorts for bond investors. In his September 22 issue, Grant cited two recent examples where bond investors seem to have lost their minds and forgotten that bonds are risky. Grant noted that a senior unsecured bond, due in 2022, issued by Carrefour S.A., the world’s second-largest food retailer after Walmart, yields just 50 basis points, or half of 1 percent annually. Period. While it is true that Carrefour has a modest debt-to-cash-flow ratio of a little more than two times, the yield on the bond suggests the company is virtually risk-free, which is almost certainly not the case. Grant also mentioned a senior unsecured bond, due in 2018, of Toys “R” Us, the toy retailer that recently filed for bankruptcy. The bond, he noted, “spent the summer vacation lounging in the vicinity of 95 cents on the dollar” before “[e]arly Septem­ber rumors of a debt restructuring inter­rupted that idyll.” The bond now trades at 26 cents on the dollar. “Like the flu, mispricing is communicable,” Grant wrote.

In case you hadn’t noticed, we live in precarious times. Our president is frighteningly unpredictable, and thrives on chaos and insecurity. His bizarre behavior has put people around the world on edge. Yet the stock market in the U.S., where the Dow Jones recently crossed 23,000, keeps hitting new highs and interest rates have stayed stubbornly low. Gundlach and Grant are right to worry that it won’t take much for interest rates to spike—sending bond prices spiraling downward—or for the stock market to suffer a major correction, after an extraordinary run that began in March 2009. “My job is to find scary things,” Gundlach told McLean. “My critics say, ‘You find seven risks for every one that exists.’ Guilty. That’s my job. My job is to try to find out what can go wrong, not cover my ears and hum. It’s better to keep your eyes open.” When an expert such as Gundlach speaks, it generally pays to listen.

As Trump likes to remind us regularly, via Twitter, the singular accomplishment of his administration is one stock-market record after another. But the major propellants of the stock market these days are the economy Trump inherited, the tax cuts that may turn out to be a chimera, and an overinflated bond market that misprices risk every day. When it all comes crashing down, will Trump take credit for that too?

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